Gattaca PLC provides human capital services, specifically staffing, within the technology sector across the world. The stock had a volatile 2016 as fears of Brexit mounted in early in the year and carried on until the vote on the 23rd of June.

INDUSTRY

Recruiting firms generally make money in one of two ways: hourly or one-time fees. Under the hourly scenario, the client outsources its staffing department to the staffing firm. Under the one-time scenario, the client wants to fill a single position and reaches out to the staffing firm. The staffing firm assigns the client to an employee, and the employee has to present qualified candidates to the client. If the presented employee is hired, then the client pays the firm a one-time fee. The relationship is beneficial to the client because the client retains a flexible cost structure by outsourcing. Staffing firms have no moats and tend to compete on price. The larger firms have name recognition advantage and are more likely to land hourly gigs.

RISKS

TECHNOLOGY

Internet job boards such as Indeed have dramatically eased the job application process. One would think that this would eliminate the need for need for recruiters and staffing firms, but the truth is that it has never been different. Recruiters have always been the middlemen in a job search, the difference between today and 30 years ago is online job-boards and newspapers. Unlike most industries that get engulfed by technological innovations, staffing and recruiting firms are fortunate to participate in the revolution though margins are much lower than they were three decades ago.

BREXIT

British economic indicators displayed knee-jerk reactions post the Brexit vote. Employers were on edge — they pushed out imminent projects and delayed hiring. No one truly knows how Brexit will play out, but if history is any guide, markets tend to negatively overreact to events that are not supported by the status quo and remain at ease when events supported by the status quo take place. This error inevitably corrects itself over the long run. We saw the same thing right after the Brexit vote — FTSE and the Pound Sterling crashed as knee-jerk, and then the FTSE subsequently recovered and rallied to all-time highs because the Sterling depreciation devalued British equities. The outlook was that the British economy was heading for an “imminent recession” but we’re nearing the first anniversary of Brexit, and economic growth has been better than expected. The same thing happened after the election of President Trump or even whenever polls indicated that he was closing into Clinton. Markets were afraid; pundits expected a ‘market crash’ but eventually markets came about to pricing in his ‘reflationary’ policies. Markets err all the time but tend to correct mistakes over the long run.

I outlined a history of large-scale economic events Britain had to deal with in the past in the Q4 performance post. What becomes apparent is that the consensus argument is always something along the line of “If X event does not play out Y way, then we’re headed for a depression.” In every single scenario, however, economic growth ended up well above-average even though the event did not play out the way the consensus expected. Britain is still excelling, and I believe she will continue to regardless of her European Union membership status. The complexities that Engineering and Technology firms — who seek highly skilled employees — face will remain unchanged in the aftermath of Brexit, be it ‘hard-‘ or ‘soft-.’ So even if the risks that the consensus expect materializes, the company will still exist because its existence is impervious to Brexit. The end game question here is – will Tech and Engineering firms need talent in 5 years? The answer is Yes.

CYCLICALITY

Staffing companies are directly cyclical because they deal directly with unemployment. When the economy turns down, companies decrease hiring, and recruiting firms find it difficult to place employees. The cyclicality of the business is a risk, but I believe the risk is dependent on the price paid for it. Brexit ‘depression’ sentiment is already reflected in the price so this could be a tailwind going forward. The CapEx-light aspect of the business and the highly variable employee compensation structure helps mitigate the severity of its cyclicality. Staffing firms that aren’t over-leveraged will generally survive a downturn. Staffers on the one-time fee model get paid by the client only when they place an employee, so there is almost no downside to utilizing the staffer. Gattaca’s net margin (<2%) is among the lowest in the industry, so there is also minimal risk of margin compression.

CATALYSTS

EASIER COMPS FROM BREXIT

The company struggled post the Brexit vote because employers chose to delay hiring, but all isn’t lost. GATC reported earnings three weeks ago and said that profits were expected to come in 10-15% below expectations because of one-time overhead expense to support a ‘pan-European’ contract win. Management was a bit ambiguous, but I assume that it is related to post-Brexit preparations. This is positive since the challenge for most companies is top-line growth.

WEAK-STERLING TAILWIND

The devaluation of the sterling is a catalyst here because companies will raise prices to adjust for the depreciated currency. The stock has fallen since the devaluation, so there is still hope for easier comps even in a weak macro environment.

VALUATION

The company, which was previously known as Matchtech, acquired Networkers PLC, and subsequently became Gattaca PLC. Matchtech in the process acquired ‘Consumer Relationship’ intangibles and per IFRS rules, has to amortize that intangible. The amortization hits the net income line but is non-cash, and so cash flow is and should continue to be greater than net income for the time being. My estimate adds approximately £2.5 million (after subtracting normalized CapEx and other intangible purchases) in non-cash expenses. There is also the restructuring costs of about £2 million that should dissipate going into next year. My estimate of normalized FCF after subtracting Stock-based compensation and other shenanigans is about £11-12 million, which places its FCF multiple at approximately 7.5-8.2x my purchase price and about 10x its Enterprise Value.

The stock pays an 8% yield on today’s price, and the dividend looks sustainable, IMO. GATC is paying out about 65% of my FCF estimate. Markets seem to be expecting a dividend cut hence the high yield, and so once the market is convinced that the company can sustain the current payout, that could be a catalyst on its own. The competition trades between 15-20x so 50% upside isn’t too much of a stretch. There has been a lot of noise in its financials given the Networkers acquisition, but this should dissipate going into the latter part of the second half of the year. Hopefully, clarity ensues and the stock is revalued to the multiple it deserves.